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Cost Allocation

In most organisations, cost data are collected on a different level of granularity or attached to another dimension as we would like to see the cost data.

Two examples.

Cost data, such as advertisements or publicity may be collected at product group level whereas we would like to present the cost data on individual products. This can be understood as advertisements are made for, say, chocolate whereas we would like to see the cost data that are attached to an individual bar. This would allow to compare the sales price to the total cost price of a chocolate bar to see if it is sold at a profitable price or not.

Cost data may also be acquired with cost centres (such as the HR department) whereas we would like to know how much costs is made with the sales data that are collected with the profit centres. In that case we would like to infer if the profit centre sells their products at a price that covers all direct and indirect costs.

We are confronted with the question on how to spread costs to individual products. Or alike: how to divide the costs on, say, HR to sales departments.

I have read on three different methods how to do this. The first method is almost trivial: do not do it. Do not spread the costs, do not allocate the costs. Just look at total turnover, direct costs and total indirect costs and see if profits are made.

The second method is more adequate as then a factor is taken that is used to divide the costs. One may think of sales turnover. For each product and every profit department, one may calculate the percentage turnover in total turnover. The resulting set of factors can then be used in the division process. If a chocolate bar takes 2% of total chocolate sales, we may account 2% of advertisement costs on chocolate as being attributed to indirect advertisements costs for chocolate bars. Likewise: if department A sells 10% of total sales, we take 10% of HR costs as being attributable to department A.

The third method assumes that we have different allocation factors for different cost groups. Hence advertisements may be allocated on base of turn over, HR on base of the number of employees, maintenance on capex outlays etc. The idea is that such allocation is closely related to the actual driver for which costs are incurred. This would then be more acceptable for the managers of a profitcentres who would like to see a close relation between his activities and the internal costs for which he is held attributable. It is not a pleasant idea to receive a large internal costs invoice for warehouse activities if the department does not have activities for which a warehouse is necessary.

A good method for allocation can be immensely important for an organisation as allocation methods have behavioural effects within the organisation. A department may try to avoid attributed indirect costs to improve departmental profit figures. I once worked in an organisation where It costs were allocated according to the number of working network sockets. The idea is good as it may be assumed the IT costs have a relation to the number of network connections. However the negative consequence was that network access was denied to people who needed it for their work to avoid IT costs.

Hence the important point is that cost allocation is important but one should create such a method to avoid unwanted behaviour. This is certainly not a trivial task as it may attribute how activities are assessed. The consequence is that the allocation mechanisme might become quite complex as multiple goals are aimed for: a fair representation of the cost structure without unwanted behavioural consequences.